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<p class="MsoNormal"><b>
<span style="font-size:24.0pt;color:black;text-transform:uppercase">Flat
Bills, Peak Satisfaction? Why a risk-hedging product for small customers
isn�t the gamble you may think.</span></b></p>
<p class="MsoNormal"><span style="color: black">From <i>Fortnightly�s</i>
<b>Energy Customer Management</b> (ECM)</span></p>
<p class="MsoNormal"><font face="Arial"><b><strong><font size="2">By
</font></strong></b></font><span style="color: black"><font size="2">
<a href="#authors">Michael O�Sheasy and Mike Becker</a><br>
</font></span><font size="2">(<em>originally published by PMA OnLine Magazine: 02/0</em>5)</font></p>
<p class="MsoNormal"><span style="font-size:10.0pt;
color:black">ECM is available free to qualified subscribers. Sign up at
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<br>
Download article in PDF format with graphs at:
<a href="http://www.pmaconference.com/flatbillsart.pdf">
http://www.pmaconference.com/flatbillsart.pdf</a></span></p>
<p class="MsoNormal"><span style="font-size:10.0pt;
color:black"><br>
</span><span style="color: black">Flat pricing. Many small electric
service customers want it, many electric companies do not think they can
provide it. That creates a market opportunity for a convenient, flat
electric bill.</span></p>
<p class="MsoNormal"><span style="color: black">We are not talking about
flat rates per kilowatt-hour, nor about a budget bill program. These
common products help customers to levelize monthly bill variance, but do
not actually protect customers from price and billing risk. To �protect�
means to shelter from risk and uncertainty. The difference between
levelizing and actually protecting the customer is where the gap lies�and
where a company can step in and capitalize.</span></p>
<p class="MsoNormal"><span style="color: black">What many small customers
really want is a pure �flat bill. � A flat bill is a fixed annual bill
that provides 12 months of equal payments with no year-end settlement.</span></p>
<p class="MsoNormal"><span style="color: black">It can even be one annual
bill. A flat bill also offers absolute predictability because it protects
against any volatility in weather, behavior and energy costs for a
specified period of time. In other words, the flat bill insures customers
against the risk of increases in cost and quantity purchased.</span></p>
<p class="MsoNormal"><span style="color: black">This flat bill concept is
not rocket science.</span></p>
<p class="MsoNormal"><span style="color: black">It is not even considered
innovative.</span></p>
<p class="MsoNormal"><span style="color: black">It is, however, the
pricing strategy of choice in many industries, including some that are
similar to the electric industry. First, there is the capacityconstrained
Internet service sector,which quickly transformed from volumetric pricing
to flat bills.</span></p>
<p class="MsoNormal"><span style="color: black">Then there is the cellular
phone service market, which has evolved from pure volumetric pricing to a
more customized menu of flat offerings. Even the volatile retail gas
market has been experimenting with its version of residential flat bills.</span></p>
<p class="MsoNormal"><span style="color: black">Not to be outdone, some
innovators in the electric industry recently began offering financial
hedging products that absorb risk from large customers.</span></p>
<p class="MsoNormal"><span style="color: black">Why not offer this kind of
protection to customers with small electric loads? It may sound absurd.
Sure, you might say, it�s fine for other industries, but not for the
complex and dynamic electric industry. System capacity would become
inefficient and unmanageable; peak loads would skyrocket, requiring new
investments in existing plants; or it might even damage system
reliability. Customers won�t pay for it. The absorbed financial risk would
be too great.</span></p>
<p class="MsoNormal"><span style="color: black">Regulators won�t approve
it.</span></p>
<p class="MsoNormal"><span style="color: black">If that�s your reaction,
you are not alone.</span></p>
<p class="MsoNormal"><span style="color: black">These are what we consider
the �norms� or �the box. � To think outside of this barrier, we have to
define each of these norms and then challenge them.</span></p>
<p class="MsoNormal"><b>BOTTOM LINE</b></p>
<p class="MsoNormal"><span style="color: black">� <i>Most believe flat
electric bills pose tremendous risk, but the reality is that an exciting
pricing opportunity exists.</i></span></p>
<p class="MsoNormal"><span style="color: black">� <i>The energy supplier
can manage uncertainty by gradually building program participation as it
learns to balance risk and returns, or through a risk adder.</i></span></p>
<p class="MsoNormal"><span style="color: black">� <i>The experience of
Internet and telecom service providers suggests that safe, profitable flat
fees can be constructed, and that customers will buy them.</i></span></p>
<p class="MsoNormal"><b>QUASHING THE MISPERCEPTIONS </b></p>
<p class="MsoNormal"><span style="color: black">Challenging the norms is
the strategy we adopted at Georgia Power in pursuing a flat bill option
for our small customers. The result was a flat bill pilot program rolled
out June 1, 2000, and involving 500 residential and small business
customers.</span></p>
<p class="MsoNormal"><span style="color: black">The goal of the program
was to understand the myths about the mysterious �flat bill. � To begin
with, we examined the potential hurdles and were surprised to discover
that there were few. On the surface, the idea of a pure flat bill in the
electric market is frightening, posing potential threats in terms of
capacity constraints, the price premium, revenue risk and regulations. But
when we challenged these norms through market research, load shape
modeling and product testing, we found an exciting new pricing
opportunity.</span></p>
<p class="MsoNormal"><span style="color: black">Let�s examine each of
these perceived threats and the realities we came to understand.</span></p>
<p class="MsoNormal"><span style="color: black"><b>NORM 1: SYSTEM CAPACITY
WILL SUFFER.</b> <br>
The primary reason flat bills are uncommon in our industry is the fear
that cus- tomers will change their behavior, leading to a dramatic
increase in their load demand. Although this worry is a norm, we have been
unable to find quantitative research to support it.</span></p>
<p class="MsoNormal"><span style="color: black">We used a three-prong
approach to challenge this belief. First, customers were surveyed to learn
how they would behave on such a pure flat program.</span></p>
<p class="MsoNormal"><span style="color: black">Then those results were
applied to a modeling program that analyzed and projected the impact of
these customers� behavior change on their load shape. Finally, we
conducted a pilot that metered the participants� actual energy and peak
consumption. This information was normalized to account for weather and
compared to the previously measured behavior for these customers.</span></p>
<p class="MsoNormal"><span style="color: black">The results were measured
empirically using test and control groups.</span></p>
<p class="MsoNormal"><span style="color: black"><b>REALITY CHECK</b><br>
We found that there was an increase in both energy and demand consumption.</span></p>
<p class="MsoNormal"><span style="color: black">However, the impact was
minimal; better yet, it occurred mostly during off-peak periods.</span></p>
<p class="MsoNormal"><span style="color: black">That can be explained by
the fact that most of the growth was the result of customers lowering
their thermostat setting during the summer months.</span></p>
<p class="MsoNormal"><span style="color: black">The effect of this action
was minimal during peak hours because the electric cooling system was
running full speed regardless of whether the thermostat was set at 76
degrees or lowered to 74 degrees. But during the off-peak times, when the
weather had cooled, the threshold of the thermostat setting had a greater
impact on the running time of the cooling system.</span></p>
<p class="MsoNormal"><span style="color: black">Though we found a minimal
increase in energy consumption, we believe the program can be
energy-efficient. This program is the only one for residential customers
that can accurately measure participants� change in behavior in terms of
the financial impact on their annual bills.</span></p>
<p class="MsoNormal"><span style="color: black">Typical volumetric pricing
used by weather-sensitive residential or small business customers reveals
a change in behavior from month to month, or month to the same month of
the previous year, but that is less accurate, since weather conditions
will always blur the results. Because a flat bill is based on
weather-normalized behavior, any change in demand will be accurately
quantified in the customers� next year flat bill offer. In addition,
improved efficiency will be rewarded by a lower offer regardless of the
weather. If the program is marketed correctly to inform customers of how
they could be more efficient and how the program can measure and reward
them, it could provide the means for customers to become more
energy-efficient.</span></p>
<p class="MsoNormal"><span style="color: black"><b>NORM 2: CUSTOMERS WON�T
PAY FOR IT<br>
</b>The commonly held belief is that electricity is a true commodity and
consumers will always choose the lowest-cost option. But flat bills should
not be the cheapest pricing package for the customer in the long run due
to the significant cost and quantity risk the programs place on energy
retailers. It is hard to argue this point when simply looking at marketing
factors such as price, place and promotion. But what about the fourth
element of the marketing mix, the package? We wanted to learn if customers
would recognize the value of an electric service package that provides
convenience and �peace of mind,� and if so, would they be willing to pay a
premium for it? To test this issue, we researched the price sensitivity of
residential customers through a survey. As mentioned, we also launched a
pilot program and surveyed actual participants.</span></p>
<p class="MsoNormal"><span style="color: black"><b>REALITY CHECK<br>
</b>The survey results showed that many customers valued predictability
and convenience and were willing to pay a premium in their electric bill.
The results were run through an optimization model to determine how the
premium would provide the optimal financial impact for the energy company.</span></p>
<p class="MsoNormal"><span style="color: black">Because our previous
market research predicted that pilot participants would use more energy,
the forecasted additional energy was built into the price of the flat bill
offer.</span></p>
<p class="MsoNormal"><span style="color: black">Public interest in the
pilot program far exceeded our expectations. The day after the pilot was
filed, news of it made the front page of the <i>Atlanta
Journal-Constitution�s </i>business section.</span></p>
<p class="MsoNormal"><span style="color: black">Soon, it was reported
favorably on both national radio and television�all for a 500-customer
pilot, which hadn�t even mailed promotions about the product yet. It
certainly confirmed our research that there was a need in the market.
Later, the high penetration rate gained from the mailed offers indicated
that the customers purchased the flat bill to meet their budgeting needs.
In a follow-up survey of pilot participants, 95 percent reported that the
flat bill either exceeded or met their expectations.</span></p>
<p class="MsoNormal"><span style="color: black"><b>NORM 3: RISK WOULD BE
UNMANAGEABLE<br>
</b>Risk is frightening, and it exists everywhere.</span></p>
<p class="MsoNormal"><span style="color: black">But risk is transferable.
Here the financial risk can be deflected from the customer to the
supplier, Georgia Power.</span></p>
<p class="MsoNormal"><span style="color: black">We wanted to see if this
risk could be dissected and managed. The major risk is the weather impact.
If the summer is hotter than normal and the winter is colder than normal,
the result is that the amount collected from the flat bill would be less
than the bill amount otherwise paid by the customer.</span></p>
<p class="MsoNormal"><span style="color: black">Conversely, if mild
weather occurs, then the amount collected by the flat bill would be
greater than the amount otherwise paid by the customer.</span></p>
<p class="MsoNormal"><span style="color: black">In some industries this
risk might not be manageable; however, in the electric industry it acts as
a natural hedge. In hot weather years, when the flat bill is
under-recovering, the company is generating unusually high returns from
its other weather-sensitive customers not on the flat bill. In mild
weather years, at the same time the flat bill is over-recovering, the
company is generating unusually low returns from its other
weather-sensitive customers. Some energy companies in the industry even
purchase weather insurance, a hedge the flat bill program provides for
free.</span></p>
<p class="MsoNormal"><span style="color: black">Another financial risk is
the change in individual customer behavior. During the first year it is
impossible to predict how an individual customer may respond to the flat
bill. But the overall average response can be anticipated and distributed
evenly into all customers� flat bills during the first year. In fact,
changes experienced with customers volunteering for budget billing can be
used as a good first approximation. When a customer renews their offer,
however, their actual usage with their demonstrated behavior change could
be built into the renewal offer instead of that for the average customer.
This practice in itself can be expected to reduce inefficient consumption
changes.</span></p>
<p class="MsoNormal"><span style="color: black">An additional risk is that
a customer might use more electricity during the first year than
predicted, and then decide not to renew. This �freeridership risk� can be
measured and forecasted.</span></p>
<p class="MsoNormal"><span style="color: black">The predicted impact can
then be built evenly into all future customers� flat bill offering. We
theorize that even if participants return to the traditional pricing
tariff, they will retain some residual behavioral changes that will
generate further profitable sales.</span></p>
<p class="MsoNormal"><span style="color: black">Finally, you have risk
associated with the accuracy of the cost variable going into the flat bill
pricing model. That variable includes the predicted base energy price and
fuel price, customer billing history, predicted customer behavior and the
accuracy of the weather-normalization model. How does the flat bill
compensate the supplier for these financial risks? The answer is the risk
adder. We have already determined that customers are willing to pay a
premium to have this risk transferred to the supplier, so if customer
sensitivity to the risk adder is equal to or greater than the acceptable
risk of these components, then this portion of the risk can be managed.</span></p>
<p class="MsoNormal"><span style="color: black">To manage the portfolio of
financial risks, we created a spectrum of potential outcomes based on all
risk variables. We tested the severity of these risks by creating a range
of worst-case, expected and best-case scenarios, where the risks can be
quantified and therefore managed through the flat bill price.</span></p>
<p class="MsoNormal"><span style="color: black"><b>REALITY CHECK<br>
</b>The financial results of the pilot during the 12-month period
supported the hypothesis that the risk could be managed. The actual
outcome fell within the risk spectrum and very close to where we predicted
given the actual outcome of each risk variable. That does not mean that
the financial results were positive. In fact, during the 12-month period
we experienced a hot summer, a mild winter and an increase in fuel price.
Though that caused Georgia Power to see a negative financial impact for
the flat bill customers, it supported the natural hedge theory because the
company earned a higher than normal return from weather-sensitive
customers not taking the flat bill.</span></p>
<p class="MsoNormal"><span style="color: black">The program is not
designed to win every year; rather, it�s designed to earn a given return
over multiple years. The scenario is similar to the bet a casino wagers.
On any given roll, a customer can beat the house, but over a course of
multiple rolls, the odds are set so that the house comes out ahead.
Referring back to the free-ridership risk, most casinos �bet� that few
winners will walk away from the table immediately after winning.</span></p>
<p class="MsoNormal"><span style="color: black">The analogy with the flat
bill is that even those few who leave the program will maintain higher
consumption habits, which have become embedded in their behavior and will
be captured in normal tariffs. The trick is managing the risk.</span></p>
<p class="MsoNormal"><span style="color: black"><b>NORM 4: REGULATORS
WON�T APPROVE IT<br>
</b>Even if the potential load growth is manageable, customers want it and
the risks can be managed, many suppliers believe that commissioners in
regulated regions will be opposed to the program�s innovation and risk.</span></p>
<p class="MsoNormal"><span style="color: black">It�s easy to understand
why regulators would scrutinize this product. The industry norms suggest
that there are established opinions against such a product. But we
believed that by challenging each of these norms through market research,
modeling and risk analysis, this product could be approved and introduced
into the regulated electric market.</span></p>
<p class="MsoNormal"><span style="color: black">After all, IPALCO had
received regulatory approval in 1998 and offered a similar product ever
since. In addition, we could address regulatory concerns through standard
regulatory accounting to shelter regulated non-participants of the program
from flat bill risk, exposing only utility stockholders.</span></p>
<p class="MsoNormal"><span style="color: black"><b>REALITY CHECK<br>
</b>In June 2000, Georgia Power received regulatory approval for a
one-year pilot with a maximum number of 500 participants.</span></p>
<p class="MsoNormal"><span style="color: black">The utility recently
earned approval to expand the offering to 100,000 customers with no cap on
participation.</span></p>
<p class="MsoNormal"><b>MANAGING FLAT BILL RISK<br>
</b><span style="color: black">Energy companies can manage the financial
return of a flat bill program based on its appetite for risk. It�s kind of
like having your foot on your car�s accelerator: You can press down to go
faster or release it to slow down. Likewise, there are two simple methods
to control your risk and return.</span></p>
<p class="MsoNormal"><span style="color: black">The first method is
managing the number of participants <i>(see Figure 1)</i>. You can phase
the program in by offering a small pilot, then slowly expand eligibility
to larger markets. That can give you time to assess risks and returns and
make small adjustments to the pricing model, as well as to the program�s
terms and conditions.</span></p>
<p class="MsoNormal"><span style="color: black">The second method is to
manage risk through a risk adder <i>(see Figure 2)</i>. The risk adder is
the premium charged to compensate the company for the additional risk it
assumes. In any given year, the program could take in more or less money
than what customers would have paid under the tariff-based,
volumetric-pricing plan.</span></p>
<p class="MsoNormal"><span style="color: black">Increasing the amount of
the risk adder increases the likelihood that in any given year, the
revenue outcome for the company will be a gain. Of course, the larger the
risk adder, the smaller the participation rate.</span></p>
<p class="MsoNormal"><span style="color: black">In an industry built on
the bricks and mortar of unit price efficiency, some will continue to
scoff at this pricing innovation, dismissing flat bills because of the
perceived inefficiency. We suggest those skeptics carefully examine the
many industries offering flat bills. Consider the Internet service
providers offering unlimited use for $19.95 per month; the
telecommunications firms hawking unlimited use at $60 a month; and auto
rental companies with unlimited miles for $40 per day.</span></p>
<p class="MsoNormal"><span style="color: black">There is a market niche
yearning for such a product, and it can be constructed safely and
profitably. It simply requires that you clearly define the norm and
logically address it. If you don�t, someone else will.</span></p>
<hr>
<p class="MsoNormal"><span style="color: black"><a name="authors"></a>
Michael O�Sheasy retired in May from his position as product design
manager for Georgia Power Co. to pursue a consulting career as vice
president with Christensen Associates, Madison, WI. O�Sheasy has 20 years�
experience in the electric industry as a costing and pricing expert
witness and an innovator with such pricing products as real-time pricing,
multiple load management and price-protection products. Contact him at
<a href="mailto:[email protected]">[email protected]</a>.</span></p>
<p class="MsoNormal"><span style="color: black">Mike Becker recently left
Georgia Power, where he was a senior pricing analyst, to become a pricing
manager with BellSouth.</span></p>
<p class="MsoNormal">P<span style="color: black">rior to his work at
Georgia Power, Becker was a pricing analyst for Conrail in Philadelphia.
In addition to the design of Flat Bill, Becker was instrumental in
developing another innovation called the Interruptible Exchange Service.
He may be reached at <a href="mailto:[email protected]">
[email protected]</a>.</span></p>
<p class="MsoNormal"><span style="color: black">ECM is available free to
qualified subscribers. Sign up at
<a href="http://www.pur.com/ECMSignUp.html" style="color: blue; text-decoration: underline; text-underline: single">
<span style="color: black; text-decoration: none">
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<br>
Download article in PDF format with graphs at:<br>
<a href="http://www.pmaconference.com/flatbillsart.pdf">
http://www.pmaconference.com/flatbillsart.pdf</a></span></p>
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